Warning – the eurozone is still on the danger list

The Eurozone economy has contracted every single quarter since the end of 2011. During the first three months of 2013, the region’s GDP shrank by a punishing 0.6pc, having fallen at a similar pace the quarter before.

Responding to this prolonged slump, the European Central Bank on Thursday cut interest rates. Having last shifted 10 months ago, the ECB lowered its main rate by a quarter point to 0.5pc, while signalling it is prepared to go even further. “We remain ready to act if needed,” said ECB President Mario Draghi.

The Eurozone has now finally joined the Anglo-Saxon economies in arriving at “ultra low” base rates. The Bank of England slashed its main interest rate to 0.5pc back in March 2009, in the aftermath of the sub-prime crisis. This was soon after the US Federal Reserve went all the way down to 0-0.25pc at the end of 2008.

While Eurozone rates were gradually loosened to 1pc in mid-2009, inflation-conscious Germany strongly resisted following the rate-slashing actions of other “leading” central banks. Under pressure from Berlin, the ECB actually raised rates a couple of times during the first half of 2011. Since the European economy renewed its nose-dive, though, rates have steadily been cut.

With eurozone inflation at 1.2pc, its lowest since February 2010, ECB policy-makers argue they have “room” to cut. The real driver, though, is unemployment. In March, the single currency region registered a jobless total of almost 20m people, a record 12.1pc of the working age population. This terrible composite figure hides, of course, a multitude of extremes. While Germany has unemployment of just 5.1pc, in Portugal some 17.5pc of the labour force isn’t working. In Spain and Greece, the figures are 26.7pc and 29.1pc.

UK-based observers could be forgiven for thinking that, aside from the recent pyrotechnics in Cyprus, the eurozone’s broader economic crisis was easing. During the summer of 2012, Draghi “persuaded” Angela Merkel that buying up the sovereign bonds of large fiscally challenged Eurozone members was the right thing for the ECB to do. While such purchases have yet to happen, the German Chancellor hasn’t yet shot down the policy in flames. So financial markets have taken it as given that such circular bond-buying, if needed, will happen.

Last year, both Spanish and Italian 10-year government bond yields tested the 7pc-plus twilight zone, a level at which default soon becomes inevitable for slow-growing, highly-indebted industrialised countries. While the likes of Ireland and Greece can be bailed-out, economies such Spain and Italy – eight to twelve times bigger than “peripheral” members – pose possibly insurmountable funding problems.

Hence the slew of alarming euro-related headlines last summer, resulting in serious jitters on global stocks markets as fears rose of another “systemic” event – this time stemming not from US sub-prime but from Eurozone sovereign debt.

Since then, the Draghi-Merkel “deal” has led to a steady fall in Italian and Spanish 10-year sovereign bonds, with both now trading at around 4pc – still relatively high, but away from the danger zone. Financial investors everywhere have been toasting “Super Mario”. As such, with the threat of an immediate bond market spectacular averted, the politicians have been less panicky and newsflow from the Eurozone has improved.

Yet while financial markets have pointed to a eurozone recovery, with investment-bank-based economists repeatedly issuing widely-cited forecasts of a convincing growth-spurt, such confidence is yet to extend to European business leaders beyond the financial sector – which, of course, amounts to the vast majority.

Equity and bond investors, for now, are desperate for good news. As such, traders are convinced Merkel will let Draghi do pretty much whatever he wants to prop up Eurozone sovereign bond prices and keep yields low. The show must go on, the argument goes, and the German government will hold its nose and allow that – at least until after Germany’s September Federal elections.

In the real world, though, eurozone industrial production has declined sharply since early 2011, while rising elsewhere, including in most other Western countries. In both March and April, the region’s manufacturing PMI survey index declined shaprly, as did the EU’s Economic Sentiment Indicator, which covers not only manufacturing, but also construction, retail trade, other services and consumer confidence. The IFO business index, based on a survey solely of German companies, has also fallen over the last two months.

Why is this happening? One reason is that external demand for eurozone goods has fallen as the global economy has slowed. Another is that the region’s bombed-out banks continue to shrink their loan books while harboring massive balance sheet loses – which is why the ECB’s latest interest rate move, even if it leads to a theoretical improvement in the cost of the working capital needed to drive growth, is unlikely to improve its availability.

A major reason for the region’s economic torpor, though, is that many firms, even those with large cash balances, remain deeply reluctant to invest given on-going fears of a sovereign bond market collapse and all the economic chaos that will cause, whatever the purported bargain between Germany and Mario Draghi. What’s more, electoral losses suffered by reform-oriented politicians in Italy, France and elsewhere, together with the chaos surrounding the Cyprus bail-out, have reinforced such fears among Eurozone entrepreneurs, not least in Germany itself. Knocking 25 basis points off a largely symbolic interest rate will do nothing to alter that.

The big policy news from Eurozone last week wasn’t, in any case, the ECB’s rate cut. The big news was that, for the first time, the Brussels policy establishment has signaled its willingness to relax “austerity”, as new EU forecasts point to “longer and deeper recession than was previously anticipated”. That’s the official line, anyway.

What really happened is that the French government, amidst an outbreak of anti-German rhetoric, has unilaterally postponed reaching its previously-agreed 3pc of GDP budget deficit target until 2014. The new Italian Prime Minister – yes, one was finally appointed, more than two months after Parliamentary elections – has also just abandoned a raft of fiscal retrenchment measures. Spain, too, has once again widened its 2013 deficit estimate, while shifting its 3pc target until 2016.

Faced with such coordinated Latin intransigence, from three countries not tied to bail-out conditions yet between them accounting for half of Eurozone GDP, Germany and other creditor countries have basically had to accede to these actions, or risk enduring an explicit erosion of influence.

Abandoning “austerity”, such as it is, will do nothing to enhance growth and could do a lot to wreck it. The recent “Rogoff-Reinhardt” spat, which has raised question marks over an influential academic paper which argues that countries grow more slowly when they have sovereign debts above 90pc of GDP, has generated a lot of nonsense. While the authors’ massive statistical database may have contained a few glitches, their basic point holds. Countries with high debts grow more slowly – not least given the impact on economic dynamism when resources are diverted from the private sector.

The issue anyway isn’t whether or not there’s a universally-applicable “magic number” above which debt drags down an economy. Of course there isn’t. Economics doesn’t work like that. The point is whether or not sovereign debt has reached levels which, if market confidence ebbs, could spark a creditors’ strike and, in turn, a series of deeply-debilitating sovereign defaults.

For all the euphoria surrounding the ECB’s rate cut, and “Super Mario’s” on-going verbal gymnastics, the eurozone – with this new “austerity easing” – last week moved a step closer to such an outcome.


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